I Have a 529 Plan, but My Child Received a Scholarship. Now What?

I am a big fan of 529 Plans. A 529 plan is a college savings plan. These plans are run through individual states and provide tax benefits. Some 529 plans are prepaid tuition plans, but the majority of 529 plans are simply savings plans.

You can learn more about them here.

One of the questions people have about 529 Plans is this—What happens if I have set aside money in a 529 Plan and my child gets a scholarship? This question is asked because there is a 10% penalty, in addition to regular income tax, on the gains (as opposed to the original amount you invest) when withdrawn for non-educational purposes.

So, here’s a hypothetical scenario:

Let’s assume that the total cost of attendance for your child’s school is $75,000. You have set aside this entire amount in a 529 Plan. Well done. But then your child receives notice that they have been awarded a $25,000 scholarship. You’re excited but wonder what this means for the money in the 529 Plan. Do you just eat the penalty and taxes on the $25,000 that you no longer need?

The good news is that no, you don’t have to eat the 10% penalty. If your child receives a scholarship, you can withdraw funds, in the amount of the scholarship, from the 529 Plan without getting hit with the 10% penalty—even though the withdrawal is not for educational purposes. However, you will still pay taxes on the gains, just like you would any other investment gains not in a tax-advantaged account.

So, don’t let the potential of your child getting a scholarship stop you from using a 529 Plan. Save as if they will not get a scholarship, and if they do receive one, celebrate the reward for their hard work.